Rethinking ESG in Private Equity

June 24, 2020

A new era for ESG

We published a white paper today, which explores how PE firms could change their mindset about ESG for the coming decade. These are the main ideas, and the PDF is available for download at the button below.

The recent change in attitudes to environmental questions has been swift, and continues to gather force. The current health and social crises will accelerate changes in attitudes towards other, non-environmental dimensions of ESG factors, such as paid sick leave policies, the provision of healthcare and childcare, and other employee benefits that drive workforce engagement. Diversity and inclusion have gained new urgency. The growing financial materiality of these questions has made asset owners increasingly vocal, and GPs are now trying to catch up. GPs may be tempted to take their old ESG approach, and just do it better. We suggest a different mindset is required: one where ESG becomes a substantial corporate function and value creation tool, informing strategy and operations of the firm and of the portfolio companies.  Over time, we expect firm-wide cultural norms will shift to embrace ESG on these new terms.

  1. Growing evidence for ESG’s materiality to returns. Most academic work has reviewed public markets data on this question, mapping share prices and credit spreads on to a company’s ESG practices. Surveys of the literature find many more examples of positive relationships between ESG and corporate financial performance than negative ones. In the context of climate change, covid-19, and racial injustice, ESG factors will become even more financially material.
  2. Increased LP expectations. LP and societal expectations on ESG are increasing quickly, with respect to carbon emissions, virus-related workforce benefits, and diversity. Many LPs have multi-generational investment horizons; for them, addressing climate change will be a central driver of portfolio performance.
  3. A structural change in approach is required to address the challenge. GPs may be tempted to take their old ESG approach, and just do it better. We suggest a different mindset is required: one where ESG becomes a substantial corporate function and value lever, informing strategy and operations of a firm and of its portfolio companies, driving cross-portfolio projects and best practice sharing.  This approach can be thought of as “horizontal”— in that it is integrated into and cuts across all of the firm’s activities. A reimagined ESG approach could dramatically alter how deals are sourced, and not just confirm to an investment committee that ESG risks have been assessed.
  4. The present: ESG efforts focused on risk and compliance. In a world of rising demand for the private equity asset class, general partners (GPs) have allocated few resources to their ESG capabilities. Today’s ESG professionals often lack influence. ESG teams are small and more focused on risk mitigation than value creation. Overall, private equity’s ESG efforts lag those at public companies, which have been working on their sustainability strategies for many years.
  5. The future: Leadership, innovation, and cultural change. To close the expectations gap, firms must add or develop senior ESG leaders with strong leadership skills. These people will come from a wider range of backgrounds than most currently serving ESG professionals. Expect more automation, standardization, transparency and innovation, as well as broader pro-ESG shifts in firm culture.

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